Anti-Fraud Provisions of the Investment Advisers Act

January 1, 2012

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The quote, “Trust everybody, but cut the cards,” is attributed to Finley Peter Dunne, a Chicago-based writer, author, and humorist. Dunne was a friend of Samuel Clemens, better known as Mark Twain. The anti-fraud provisions of the Investment Advisers Act were passed to ensure that investors do not get a raw deal from a trusted advisor.

Section 206 of the Investment Advisers Act is the general anti-fraud provision governing RIAs. Even investment advisors who are exempt from registration are still subject to certain anti-fraud provisions found in Section 206. As we will explore further in Scope of the Fiduciary Duty Owed by Investment Advisors, Section 206 also creates a fiduciary duty that is owed by RIAs to their clients, whether they are state or SEC-registered.

Section 206 Statutory Language

Section 206 of the Investment Advisers Act prohibits RIAs from engaging in fraudulent, deceptive or manipulative activities. To avoid violating Section 206, RIAs must not engage in direct or indirect transactions that act as a fraud upon any client or prospective client. Section 206 prohibits misstatements, as well as omissions of material facts. According to the case of Steadman v. SEC, 603 F. 2d 1126, 1134 (5th Cir. 1979), aff’d 450 U.S. 91 (1981), a fact is deemed material if there is a substantial likelihood that a reasonable investor would consider it to be important.

Sections 206(1) and (2) state that it is unlawful for any RIA to utilize any device, scheme, or artifice, in order to defraud any client or prospective client. RIAs must also refrain from engaging in any transaction, practice, or course of business that operates as a fraud or deceit upon any client or prospective client. These sections of the Investment Advisers Act are the foundation of the fiduciary duty owed by RIAs to their clients. For example, it would be deceptive for an RIA to solicit clients with promises of a guaranteed return from certain investments or false statements about the firm’s track record. It would also be fraudulent or deceptive for an RIA to assure prospective clients that an investment is risk-free.

Introduction to Fiduciary Duty

Many IARs were in the financial services profession long before they became associated with an RIA. Perhaps, they sold insurance or worked as a registered representative for a broker-dealer. Many decided to work for an RIA or start an advisory firm, so they could focus on giving advice and not selling a particular policy or investment product.

Making the shift from a sales orientation to a fiduciary relationship is not always easy. RIAs owe a fiduciary duty to put their clients’ interests ahead of their own and to disclose all material conflicts of interest. For example, an RIA that is still affiliated with a broker-dealer must disclose to clients the potential conflicts of interest that arise from that relationship. When an RIA is dually-registered, clients’ transactions must be executed through that broker-dealer, which means that brokerage fees may be higher.

RIAs must also treat their clients impartially and avoid favoring one client over another. For instance, an RIA may not favor one client by giving that person access to potentially lucrative initial public offerings (IPOs). RIAs also owe an affirmative duty to their clients of full and fair disclosure of all material facts. These disclosures are made in the firm’s Form ADV, which we will discuss in The New and Improved Form ADV.

As fiduciaries, RIAs must refrain from engaging in prohibited transactions. For example, an RIA may not assign an advisory contract to another firm without the client’s consent. Furthermore, RIAs may not use advisory contracts containing contractual language that seeks to limit or avoid their civil liability for mistakes made in managing the client’s money. In addition, RIAs must make full disclosure of their fees, investment strategies, and business practices.

Other financial services professionals are not held to this same high standard. For example, registered representatives for a broker-dealer are not usually held to this standard, unless there are special circumstances or state court decisions impose a fiduciary obligation on them. The Dodd-Frank Act ordered the SEC to study whether RIAs and broker-dealers should be subject to a uniform fiduciary standard. That study was released in January, 2011, and recommended that broker-dealers be subject to the same fiduciary standard as RIAs. It remains to be seen if there will be a harmonization of the fiduciary standard applied to RIAs and broker-dealers. AdvisorOne reported in a posting on December 1, 2011, that industry and consumer officials are unsure if and when the fiduciary mandate will come to pass. The SEC is being pressured by Capitol Hill to conduct a more robust economic analysis of the fiduciary standard’s impact. There is also concern that the fiduciary standard will be challenged in court.

It is not always clear-cut as to whether an IAR owes a fiduciary obligation to clients. For example, IARs of an advisory firm may hold a license to sell insurance. When IARs stop giving investment advice and begin selling insurance to clients, they do not necessarily owe a fiduciary duty to them. Much depends upon the facts and circumstances of the situation. Nevertheless, the fact that an IAR may earn commissions from the sale of insurance policies must be disclosed to clients in the RIA’s Form ADV, which is the firm’s disclosure brochure.

As we move forward in this book, we will pay special attention to the rules implemented by the SEC to flesh out the obligations owed by virtue of Sections 206(1) and (2). These rules help clarify the act, passed by Congress. For example, restrictions on advertising are found in Rule 206(4)-1 under the Act. State-registered RIAs are governed by similar state regulations that are often modeled after SEC rules. Some states incorporate—by reference—SEC rules in lieu of creating their own regulations.

The Big Picture

In response to an article I wrote for RIABIZ.com, an IAR took issue with my statement that advisors should act like fiduciaries in their dealings with prospective clients. The IAR stated that there is no duty to act like a fiduciary until the parties enter into a legally-binding relationship.

RIAs and IARs should view themselves as fiduciaries at all times, whether they meet the legal definition or not. If they deviate from the fiduciary standard of full disclosure while courting clients, they will cause themselves significant problems down the road. I would hate to think that IARs tell themselves they are not a fiduciary yet, so they can be less than forthcoming in their marketing efforts and interactions with prospective clients. They are still bound by the requirement in Sections 206(1) and (2) that requires them to avoid fraud and deceit in their dealings with prospective clients.

Policies and procedures can help to ensure that RIAs and IARs avoid fraudulent, deceptive, or manipulative conduct. They can also improve the odds that the firm and its employees fulfill their fiduciary obligations.

Les Abromovitz

Les Abromovitz is the author of The Investment Advisor’s Compliance Guide, published for 2012 by The National Underwriter Company/Summit Business Media. Les Abromovitz is an attorney and member of the Pennsylvania bar. Les has handled hundreds of consulting and publishing project for a leading compliance and regulatory services firm. He has conducted a number of seminars and training sessions dealing with compliance subjects. Les is also the author of several White Papers that analyze compliance issues impacting Registered Investment Advisors (RIAs).

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